L23
Externalities
Road map
1) Consumers choice
2) Equilibrium, Producers
(Pareto efficiency)
3) Market Failures
- fixed cost: monopoly and oligopoly
- externalities and public goods
- asymmetric information
Externalities
 So
far: utilities on own actions only
 Reality:
 An
we are not islands
externality is a cost or a benefit imposed
upon someone by actions taken by others.
- benefit - positive externality.
- cost - negative externality.
Examples of Negative Externalities
 Air
or water pollution.
 Loud parties next door.
 Traffic congestion.
 Second-hand cigarette smoke.
 Increased insurance premiums due
to alcohol or tobacco consumption.
 Bad smell!
Examples of Positive Externalities
A
well-maintained property.
 High “human” capital
 A pleasant cologne or scent worn by
the person seated next to you.
 A scientific advance.
Today’s questions:
 Interactions
with externalities
 Too much or too little activity?
 How
can we reestablish Pareto efficiency?
– taxes
– creating markets
– social norms
Example: Negative externality
 Two
producers: steel mill and fishery
 A steel mill produces steel s
 It can also choose the level of pollution
TC s ( s , x )  s 2  ( x  1) 2
pollution x adversely affects a
nearby fishery
 The
TC f ( f , x )  f
2
 xf
x
Steel mill problem
 s (s, x)  ps s  TC s (s, x)
Steel mill problem
TC s ( s , x )  s  ( x  1)
2
2
p s  $2
s
x
s 
Fishery problem
TC ( f , x)  f
2
 xf
p f  $3
 f ( f , x)  p f f  TC f ( f , x)
f 
f 

f
s 
Pareto efficient pollution
 ( s , f , x )  p s s  TC s ( s , x )  p f f  TC f ( f , x )
Pareto efficient pollution
Pareto efficient pollution
TC s ( s , x )  s  ( x  1)
2
TC f ( f , x )  f  xf
2
2
p s  $2
p f  $3
Comparizon
negative externality – too much
activity in decentralized markets
 You will show in PS that when externality
if positive – too little activity.
 When
Implementation: Pigouvian Tax
 s (s, x)  ps s  TC s (s, x)   x
 Problem:
information!
Missing markets
 s (s, x)  ps s  TC s (s, x)  p x x
 f ( f , x )  p f f  TC f ( f , x )  p x x
Social norms: moral cost
 (s, x)  ps s  TC s (s, x)   x
norm: “do not pollute”
 Moral cost  ( x )
 Many norms can be explained using
efficiency argument
 Social